Mechanics of Options Markets

1
Mechanics of Options Markets
2
The size of option market and importance of
options

• The size of option market size is far smaller
  than futures markets. However, as a nonlinear
  derivative product, its theoretical significance
  is far greater than other linear products.

3
Options

• A call option is an option to buy a certain
  asset by a certain date for a certain price (the
  strike price)

• A put is an option to sell a certain asset by a
  certain date for a certain price (the strike
  price)

4
Types of Options

• A European option can be exercised only at the
  end of its life
• An American option can be exercised at any time
  before the contract expires
• There are many other types of options
• Parisian option Many convertible bonds are
  Parisian options
• Asian options Average price as strike price

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Specification ofExchange-Traded Options

• Expiration date
• Strike price
• European or American
• Call or Put (option class)

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Long Call on Microsoft

• Profit from buying a European call option on
  Microsoft option price 5, strike price 60

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Short Call on Microsoft

• Profit from writing a European call option on
  Microsoft option price 5, strike price 60

8
Long Put on IBM

• Profit from buying a European put option on
  IBM option price 7, strike price 90

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Short Put on IBM

• Profit from writing a European put option on
  IBM option price 7, strike price 90

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Payoffs from OptionsWhat is the Option Position
in Each Case?

• K Strike price, ST Price of asset at
  maturity

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Terminology

• Moneyness
• At-the-money option
• In-the-money option
• Out-of-the-money option

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Terminology

• Intrinsic value
• Value realized if exercised immediately
• Time value
• Value over level of intrinsic value
• Example
• Spot price 53 strike price 50 Call option
  price 5
• Intrinsic value 53 50 3
• Time value 5 3 2

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Market Makers

• Most exchanges use market makers to facilitate
  options trading
• A market maker quotes both bid and ask prices
  when requested
• The market maker does not know whether the
  individual requesting the quotes wants to buy or
  sell

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Warrants

• Warrants are options that are issued (or written)
  by a corporation or a financial institution
• The number of warrants outstanding is determined
  by the size of the original issue and changes
  only when they are exercised or when they expire

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Warrants(continued)

• Warrants are traded in the same way as stocks
• The issuer settles up with the holder when a
  warrant is exercised
• When call warrants are issued by a corporation on
  its own stock, exercise will lead to new stocks
  being issued

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Executive Stock Options

• Option issued by a company to executives
• The purpose
• When the option is exercised the company issues
  more stock
• Usually at-the-money when issued
• They cannot be sold
• They often last for as long as 10 or 15 years

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Executive Stock Options continued

• What executives do when they are issued options?
• Business Week, September 23, 2002 Finance --
  Stock repurchases can enrich execs at investors'
  expense
• Execs may forfeit investing in projects with long
  term value so they have extra cash for
  repurchasing stocks, or the cash reserve becomes
  lower than it should be.
• Discussion Is there a perfect substitute?

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Employee options

• Startup or young companies often issue employee
  options.
• If companies do well, early employees can become
  very wealthy. It is an very effective way to
  stimulate employees.
• Bill Gates attributed the rapid growth of
  Microsoft in great part to its employee option
  program.
• Do employee options have similar effect for large
  and mature companies?

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Convertible Bonds

• Convertible bonds are regular bonds that can be
  exchanged for equity at certain times in the
  future according to a predetermined exchange ratio

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Convertible Bonds(continued)

• Very often a convertible is callable
• The call provision is a way in which the issuer
  can force conversion at a time earlier than the
  holder might otherwise choose
• Amazon

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• Given that the value of an asset is affected by
  many factors and represented by relatively few
  financial instruments such as stocks and bonds,
  the financial market is far from complete. It is
  reasonable to expect that some derivative
  securities are created to better represent the
  values of the underlying assets. The convertible
  bond is an example.

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• For young and small firms not rated by a rating
  agency, it is difficult to issue straight bonds
  with low yield. At the same time, they may not
  want to issue additional shares at the current
  price level for this will dilute their ownership.
  Usually, small firms are volatile, which is often
  considered an unfavorable feature of a firm.
  However, the design of the convertible bond turns
  this feature into a positive one. The call
  options are highly valued since volatility is
  high for small firms. Because of the call option
  on the equity, convertible bonds pay lower coupon
  than the straight bonds. Since the convertible
  bonds properly represent the features of young
  and small firms, they have become increasingly
  popular among these firms, especially among high
  tech start-ups.

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Price and volume of China Travel Why trading
volume is so high on some days?
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Some background information

• Parisian option. The option can be exercised only
  after the stock prices are over the strike price
  for a period of time. This feature is designed to
  prevent manipulation of share prices.
• To force the conversion of the China Travel
  convertible bond into common shares, the daily
  closing price of China Travel stock had to stay
  over 5.49 HK dollars, the call price, which was
  150 of the conversion price, for more than
  twenty of thirty consecutive trading days.

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• On August 6, 1997, the share price of China
  Travel went over the call price of HKD 5.49 for
  the first time. At that time, share prices of
  China Travel were higher than its CB prices,
  which is theoretically impossible. Figure shows
  the unusually high trading volume around that
  time, indicating strong market manipulation.
  However, the financial markets around Asia turned
  very bearish soon and China Travel managed to
  support its share price over the call price for
  nineteen days before it succumbed to the sharp
  fall of the general market.
• For all its effort, China Travel could not
  convert the bond into equity.1 The failure of
  conversion of China Travel gave a clear sign of
  the trend reversal. 2

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• 1 According to the equity value of China Travel
  at the end of 1998, it would have made over sixty
  six million US dollar profit if the conversion
  had been successful, comparing with the total
  profit of seventeen million US dollar for the
  first half of the 1998.
• 2 A trader confirmed that he spotted this
  signal and used it in trading. Several traders in
  different firms told me that borrowing shares of
  China Travel at that time was very difficult,
  although they didnt understand why.

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Homework

• A trader buys a call option with a strike price
  of 45 and a put option with a strike price of
  40. Both options have the same maturity. The
  call costs 3 and the put costs 4. Draw a
  diagram showing the variation of the traders
  profit with the asset price.

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Homework

• Explain why an American option is always worth at
  least as much as a European Option on the same
  asset with the same strike price and exercise
  date.
• Explain why an American option is always worth at
  least as much as its intrinsic value.